How to Sell Short when Day Trading

Most brokerage firms make selling short easy. As a day trader, you simply place an order to sell the stock, and the broker asks whether you’re selling shares that you own or selling short. If you place the order selling short, the brokerage firm goes about borrowing shares for you to sell. It loans the shares to your account and executes the sell order.

You can’t sell short unless the brokerage firm is able to borrow the shares. Sometimes, so many people have sold a stock short that no shares are left to borrow. In that case, you have to find another stock or another strategy.

When the shares are sold, you wait until the security goes down in price, and then you buy the shares in the market at a bargain. You then return these purchased shares to the broker to pay the loan, and you keep the difference between where you sold and where you bought — less interest, of course.

The stock exchanges are in the business of helping companies raise money, so they have rules in place to help maintain an upward bias in the stock market. These rules can work against the short seller. The key regulation is what’s called the uptick rule, which means you can only sell a stock short when the last trade was a move up. You can’t short a stock that’s moving down.

A trader borrows 400 shares selling at $25 each and then sells them. If the stock goes down, she can buy back the shares at the lower price, making a tidy profit.

If the stock stays flat, she loses money because the broker will charge her interest based on the value of the shares she borrowed.

And if the stock price goes up, she not only loses money on the interest expense, but she is also out on her investment.

The interest and fees that the broker charges those who borrow stock accrue to the broker, not to the person who actually owns the stock. In fact, the stock’s owner will probably never know that his shares were loaned out.

Investors — those people who do careful research and expect to be in their positions for months or even years — look for companies that have inflated expectations and are possibly fraudulent. Investors who work the short side of the market spend hours, usually doing careful accounting research, looking for companies that are likely to go down in price someday.

Day traders don’t care about accounting. They don’t have the time to wait for a short to work out. Instead, they look for stocks that go down in price for more mundane reasons, like more sellers than buyers in the next ten minutes.

Most day traders who sell short simply reverse their long strategy. For example, some day traders like to buy stocks that have gone down for three days in a row, figuring that they’ll go up on the fourth day. They’ll also short stocks that have gone up three days in a row, figuring that they’ll go down on the fourth day. You don’t need a CPA to do that!